Friday, November 21, 2008

The fear behind Berkshire's free fall

I ought to have talked about it in the post about Berkshire's valuation. The reason is simple: Any time you believe there is a discrepancy between price and value for a particular security, it pays to understand why the discrepancy arose. Once you do, you can then make a reasonable assessment of whether the discrepancy is real or imagined. 

Over the last couple of days, there have been reports on Bloomberg and other sources that the cost of insuring Berkshire's debt has almost tripled over the last couple of months from 140 basis points to 415 basis points i.e. the cost of protecting a 100$ of debt owed by Berkshire went from $1.40 to $4.15. 

Median for Baa3 rated debt(lowest level of investment grade debt) was 348 basis points, compared to Berkshire's 415. If there's a more obvious illustration of irrational fear in the credit markets, I'd like to see it. Someone's going to make a ton of money shorting the Berkshire CDS' at these prices, perhaps more than someone thats just buying the equity. 

The fear(caused by the rising cost of Berkshire's debt protection) is that Berkshire will lose its AAA credit rating which would be an obvious blow to their insurance business, especially the super-cat business. Much as the rating agencies have behaved abominably during the real estate bubble, I'd seriously doubt a downgrade of Berkshire is in the works. Never say never I suppose, but lets see why fears of a credit downgrade are overblown.

The apparent(because I cant know for sure) reason for the surge in cost protection of Berkshire's debt is the equity index put options that have been written by Berkshire in the last few years. Lets forget the accounting for a minute and look at the economics of the transaction. 

1. Berkshire was paid $4.85 billion upfront in premiums for the put options.
2. The put options were written at market values for 4 stock indexes, 3 of them foreign over various times in the last 5 years.
3. Each of the contracts has a term ranging from 15-20 years.
 4. The options are European-style(which combined with the timeframe makes the transaction virtually risk-free for Berkshire), which means that they cannot be exercised except on the date of expiration.
5. The notional exposure on these contracts at the end of Q3 of 2008 was $37.042 billion.

So, what does Berkshire's bet mean? Simplifying for a minute (assume that the puts were written on one stock index and there's 13.5 years left on that contract, which is the average weighted remaining life on the contracts put together):

Market price of the index on the day the contracts were written: X
Market price of the index on the day the contracts expire(13.5 years from today): Y

If Y is less than X, Berkshire is liable to pay the difference to the put holder at the time of expiry of the contract, otherwise the puts expire worthless. Think about it: What are the odds that the indexes will be lower 15 years from now(approximately) than their peak, of say, last year? Free money for Berkshire, if you ask me. Add to it the fact that Berkshire gets to invest that $4.85 billion in a time of extreme financial turbulence. Brilliant timing. And the $37.042 billion in notional exposure? Thats the amount Berkshire is liable for, if all of the indexes on which these contracts are written against were trading at zero at the expiration date of these contracts. Lets just say we will have bigger problems than worrying about Berkshire's solvency if that eventuality came to pass.

Remember when I said to forget about the accounting for a minute? Well, that minute has passed and its time to understand why you see headlines in the financial media such as: "Berkshire Hathaway reports record 77 percent drop in quarterly profits".

As the market continues to decline:
1. The value of the puts(as estimated by Black-Scholes) decline. The current estimated fair value of the puts must be entered on Berkshire's books. This causes reported book value to decline.
2. The change in the value of the puts must also be applied to earnings. This means that, when the value of the puts decline, reported earnings take a hit, even though no cash payments have been made from Berkshire. This essentially renders reported GAAP earnings meaningless for analysis. The reverse is also true. When markets turn around, Berkshire will report "profits" from these contracts even though no cash payments will have accrued to Berkshire during that period. You can also expect the financial media to go ga-ga over these reported numbers and praise WEB's genius at that time. 

I hope this explains the fear behind Berkshire's drop and the irrationality of the fear. 

As WEB has said(paraphrasing): "To put up runs on the scoreboard, one must look at what's happening on the playing field, not whats happening on the scoreboard". 

On the scoreboard: Declining quoted prices for Berkshire's equity holdings, the "losing" put positions etc.

On the playing field(since the 3rd quarter only, Berkshire's been deploying plenty of cash since the end of last year): Berkshire buying 10% yielding preferreds in GE and GS(with an equity kicker to boot), MidAmerican buying CEG for a fraction of what it was worth at the start of this year, and the ability to buy billions of dollars of worth of securities at depressed prices with 2 of the greatest investing minds of all time allocating capital. 

I'd suggest what's happening on the playing field today will have a far greater impact on Berkshire's future net worth than what's being reported on the scoreboard. 

I'll say this again: At $77500 an A share and $2620 for the B's, Berkshire is stunningly cheap.

The obvious question from folks reading this then is: Why aren't you buying it? 
Two reasons:
1. I am fully invested at this point.
2. None of my other holdings are selling at prices close to where I would consider selling them. They aren't selling at prices close to where I bought them either, but thats another story for another day.

Often wrong but seldom in doubt,
Ragu

3 comments:

  1. Great post, Keep it coming !

    "And the $37.042 billion in notional exposure? Thats the amount Berkshire is liable for, if all of the indexes on which these contracts are written against were trading at zero at the expiration date of these contracts"

    I thought that the 37 billion $ will be paid if the indexes go below their puts value. No ?

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  2. Hi Qleap,

    Nope. The liability for Berkshire ranges from zero(indexes are trading at the same price as when the put contracts were written) to 37.042 billion(indexes are at zero). If the index is trading at any point in between these 2 values, Berkshire's liability(until the contracts expire) is determined by the Black-Scholes options valuation formula (as disclosed in their latest 10-Q). At contract expiry though, Berkshire's liability will be based solely on the market prices of the 4 indexes.

    --Ragu

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  3. thanks ragu.

    Based on conservative estimates of $75K investments per share and per share earnings of $5K @12 times earnings, it's IV would be ~ $135K.

    Thats a screaming buy !

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